Will asian replace dollar as new reserve currency?

Oct 10, 2006 • rybinski

Central banks should have a new vision regarding future role of foreign exchange reserves

The purspose of this post is to establish what changes in the world financial architecture are needed in order to allow central bankers of the world do better job in reserve management for the benefit of citizens in their countries.

US dollar holds the status of the world reserve currency, as US financial markets offer good regulation, transparency, high safety and high liquidity. There are some signs that dollar share of reserves may be falling, but it is a very slow process (see BIS report: bis_quarterly_sep_2006_reserves.pdf){#p154}

Dollar status of world reserve currency gave US possibility to enjoy “exorbitant priviledge”, see excellent paper by Gourinchas and Rey (gourinchas_rey_us_privilege.pdf){#p155}

In short this means that US enjoyed much higher return on its foreign assets that the cost of its foreign liabilites. This helped US consumer to raise standard of living.

Central bankers of the world helped US enjoy these benefits, by investing in low yielding US treasuries.

But the world is changing fast which confronts world central bankers with new challenges. How to manage sharply growing forex reserves, is the old “safety first” mantra proper when reserves are built to levels well beyond what can be justified by intervention needs or precautionary motive. XXI century calls for a change.

We need asian

When investing reserves central bank face tough limits related to credit quality and to market liqudity. At the same time that region that has the highest long-term potential growth (ASEAN 10 + China, Korea, Japan) does not offer good enough quality and liquidity. This means that many institutions cannot invest in this part of the world.

I believe that in the next decades new Asia currency will be born, I call it “asian” athough more technical names were floating around: ACU, AMU, see sample papers: ( imf_cowen_on_asia_financial_integration.pdf{#p156} ,

ogawa_on_common_asian_currency.pdf{#p157} ). There has already been some talk about common currency in on political level, such as finance minister meeting in Hyderabad in May this year, and other within the Chiang Mai initiative.

With the possible emergence of asian there will be a possibility of more equal participation in “exorbitant privilege” by US, eurozone and Asia. This will also mean that current Bretton Woods 2 arrangement cannot be sustainable. In the longer run, however, I think that asian will become the dominant world reserve currency. Most people agree that the size of Chinese GDP will top US GDP by a wide margin (30-40 percent on PPP basis), so ASEAN10+3 economies will be much larger than US or enlarged eurozone, that India will be of similar size to US economy. So world economic weight is moving to Asia, and with some delay (counted in years, not months) world foreign exchange reserves should also follow.

I leave the optimal currency area discussion aside. Will enlarged eurozone and future asian-zone fulfil OCA criteria. I do not know, but the issue of specialization does count, take a look at De Grauwe papers